In March, the Federal Reserve plans to raise interest rates for the first time in more than three years to combat inflation. For high-net-worth individuals who received a four-year reprieve when the estate exemption went unchanged last year (it remains at $12.06M per person),increasing interest rates may be another reason not to delay estate tax planning.
The following are examples of estate tax planning strategies that can be effective in a low-interest-rate environment depending on individual circumstances.
1. Intra-Family Loans
An intra-family loan allows a borrower (usually a child) to borrow money to invest in appreciating assets, pay a nominal amount back to the lender (usually the parent), with no gift tax consequences. The interest payment from the child to the parent is based on a minimum required interest rate, updated monthly by the IRS.
For example, with the current short-term rate of 0.59%, a parent could loan $1M to a child for three years and receive the $1M, plus roughly $18,000 of interest, in return. If the child invests the $1M at 5%, she would receive $158,000 of income, or a net of$140,000, at no gift tax cost. The parent may also forgive the annual interest as part of the annual gift exclusion (though the interest income is imputed on their income tax return).
2. Charitable Lead Annuity Trusts (CLATs)
For charitably inclined individuals, a CLAT is a powerful income and estate tax saving strategy. A CLAT pays qualified charities (including a donor-advised fund) an annual annuity payment for a set number of years, with the remainder passing either back to the grantor or to beneficiaries (e.g., children).
The value of the entire annuity to the charities is treated as an up-front income tax deduction to the grantor, which may be utilized all at once or carried over for up to five additional years, subject to certain AGI limitations. With low interest rates, the value of the annuity, and therefore the income tax deduction, is much greater.
In addition, since the remainder value is very low, leaving it to children allows parents to remove assets from their taxable estate at a low gift/estate valuation. In a low-interest-rate environment, this is one of the strongest combined income tax and estate tax plans.
3. Sales to Intentionally Defective Grantor Trusts (IDGTs)
Unlike a gift, a sale does not utilize an individual’s estate tax exemption. Generally, however, the sale of appreciated assets leads to recognition of gain, and a capital gains tax.
While gifts and sales to IDGTs are completed transfers for estate tax purposes, the trusts are “defective” for income tax purposes. The result is that assets in the IDGT continue to be treated as owned by the grantor for income tax purposes. This feature allows high-net-worth individuals to sell appreciated assets—business interests, real estate—without recognizing a gain. The sale is structured with a promissory note, and the IDGT begins receiving the net income from the asset(as the new owner) and uses a portion of that income to make payments back to the seller under the note.
Low interest rates, valuation discounts, the grantor’s payment of the trust’s income taxes annually, and future appreciation of the asset outside of the grantor’s estate make a sale to an IDGT one of the most effective estate tax strategies.
4. Grantor Retained Annuity Trusts (GRATs)
A GRAT allows the grantor to transfer assets to a trust, receive an annuity payment over a term of years, and pass any excess remains in the GRAT to beneficiaries at the end of the term. By “zeroing out” the GRAT—returning to the grantor the amount transferred plus a nominal required return—there is no gift tax cost and any excess appreciation is removed from the grantor’s estate.
With low interest rates, the amount that must be returned to the grantor (and therefore her taxable estate) is reduced. This strategy is most effective for individuals who have used all of their estate tax exemption or for highly volatile assets (pre-IPO stock, cryptocurrencies) in which they do not want to waste the exemption if the value of the asset decreases.
Legacy planning, including estate and tax strategy, should be a key component of your wealth management relationship. While these are examples of powerful strategies in a low-interest-rate environment, each individual’s situation is unique, and you should consult with your advisor for strategies that are right for you.
This information is presented for educational purposes only. Morton Capital Management dba Morton Wealth (“Morton”) is not an attorney, and no portion of its services should be interpreted as legal, tax or financial advice This information should not be taken as a representation that the strategies described are suitable or appropriate for any person. References to specific investments are for illustrative purposes only and should not be interpreted as recommendations to purchase or sell such securities. You should consult with your financial advisor and legal professionals to thoroughly review all information and consider all ramifications before implementing any transactions and/or strategies concerning your finances or your estate plan. Past results are no guarantee of future results. All investments involve risk including the loss of principal.